Question

Martock Corp. is also considering the recommendation of an industrial engineer firm to optimize its production facility.(discount rate of 10.7%) Management estimate that the changes to the facility will result in annual reductions in cash outflows (i.e., will result in cost savings) as follows:

• Savings in Years 1 through 4 of $6.25 mln annually

• Starting in Year 5, these savings will decline by 8% year-over-year up to and including Year 13

• Savings in Years 14 and 15 will then decline by 50% year-over-year

• Project savings will terminate at the end of Year 15

a. One alternative for undertaking this optimization is for MC to pay a one-time fee today.

i. If the cost today is $40 mln, should MC proceed with the project?

ii. What is the maximum amount that MC could spend on the project today and it still be viable?

b. A second alternative for MC is for the engineering firm to fund the initial cost of the project and for MC to make annual payments to this firm over the project’s 15-year life.

i. If the annual payments to the engineering firm are $4.75 mln, should MC undertake the project?

ii. What is the implied interest rate that the engineering firm is charging to MC under this arrangement?

iii. What is the maximum amount that MC could pay each year for the project to be viable, assuming the firm makes equal annual payments to the engineering firm?

iv. Assume that the annual payments to the engineering firm increase by 2% annually to offset inflation. What would be the value of the maximum payments in Years 1 and 15 to the engineering firm, assuming the project is viable?

Answer 1

Answer:- * According to data- Page 1 i since, the required rate of return is not given here, we will assume it to be 8% annually. so we will discount our cash flows (CF) with a discount rate of 8% to calculate the Net present value (NPV) of the project. => CF - $6.25 mn ! CF2 = $6.25 mn . CF3 = $6.25mn (CFH = $6.25mn CFG = $5.75mm CF6 = $5.29 mn CF7 = $4.87 mm CF8 = $4.48 mm . cFq' = $4-12 mn c Fio = $3.79mn cfil = $3.49mn CF12 = $3.21mn

page-2 (f 13 = $2.95 mn CFR = $1.48 mn cfig = $0.74mn. with a discount rate of 8%, we get the present values of all future cash flows to be $41.619 min which is greather than currebt cost of $ Homn. so Me should produceed with the project.. ;) Maximum amount to be invested today is when the present values of all the future cash flows is equal to the money invested, so the value will be $41.62 mn. - b) i) If the annual payment is $4.75mm, then the Cf for each year will be decreased .. by this much. ILI

Page-3 "The present value of all these payments with a discount rate of 8% is= $40.65 mn. since, it is greater than the pr of all the cash inflows , so MC should not take the project. i) Implied interest sate = {C4. 75X 15) 40)53) = 3.92 %